Economic Update 24th March – COVID-19

James Vandeloo, Head of the Lifewealth Investment Committee, provides another update on global markets and the outlook for investment portfolios in this COVID-19 period and beyond.
I would first like to acknowledge that we understand all our clients and associates are going through a troubling time at present. It is far more than purely financial, for the first time in a generation, we as Australians are facing uncertainty about our futures and the loss of our liberty, which many of us have probably taken for granted living in such a safe and wonderful place.

We know it is very difficult to stay unemotional when we are currently in an environment of fear and uncertainty. It’s very hard to stay rational when we are losing money and people around you are losing their minds.

While our hearts are also very heavy at the moment it is our job to assist you to operate to an investment plan, so we can review what our logical selves would do – and execute it.

We are hearing some horror stories on the grapevine, as no doubt you are, and there is commentary as extreme as that we are headed for a great depression now making mainstream headlines. I’m here to tell you I believe these opinions are very wrong, so hopefully, I can make the case for you to give you some comfort that the uncertainty we are now facing will end, and why I do not believe our future is as bleak as many believe today.

What is true, is that the shock to global GDP in the first half of 2020 will likely be the greatest in recorded history. A sudden stop of the global economy has never happened like this before. If there was no Government intervention, absolutely we would be facing a potential deflationary depression scenario. Unemployment is going to rise drastically over the next few months, From 5% here in Australia to above 10%, and this phenomenon will be repeated across the world.

The global health crisis due to the spread of the coronavirus makes this feel even worse, as we are helpless to get the economy working and improve our lot.

In the podcasts we recorded we speculated peak fear in markets would occur when major cities such as New York went into shutdown. That is now occurring, as it is here in Sydney and Melbourne. I never thought we would be experiencing that fear and uncertainty first hand, but that is where we find ourselves today.

The truth is as uncertain and as helpless as this makes us feel, it is sewing the first seeds of recovery from this crisis.

The positives we see on the horizon are as follows:

Governments understand a depression cannot, and will not be allowed to happen.

Antiviral drugs such as Hydroxychloroquine (which is administered simply in tablet form) is having absolute success in treating Covid 19 right now. We expect this to be widely available within the next month and will make a material difference to death rates from the virus globally until a vaccine is available next year.

The shutdowns should have fairly quick effects in reducing the spread of the virus. We expect peak infection rates in the US by mid-April and improvements thereafter. This will mark the turning point.

The monetary policy response from central banks has been astonishing. Credit will continue to flow and borrowing costs remain low for the duration of this crisis. We believe the system will not break. This is critical to our recovery.

While the fiscal response has been a bit slow, it is coming. In Australia, the Government has committed to get business through and provide income support. The UK Government has guaranteed workers 80% of their pre-crisis wages and the US is presently working on a package to the value of an astonishing $US 2 Trillion dollars (this is 10% of GDP!)

Once this US package is delivered it should appease financial markets to an extent and begin to reduce volatility.

The key take away from the above is that Governments and Central banks are going to hold things together until we can get back to work. The unemployment spike will reverse very quickly as things improve in the 3rd quarter of 2020. This is why we won’t be suffering a depression.

We believe the banks are not at any risk of failure in Australia and will be supported unconditionally by the RBA. While defaults will rise, they should not be higher than 2% due to the policy response.

While property prices in Australia are likely to come under some short term pressure, we doubt the fall will be more than 10% as unemployment recovers quickly and borrowing costs remain historically low.

While it is unlikely our lives will return to complete normalcy within 12-18 months (we doubt there will be much international leisure travel until there is a broadly available vaccine) we believe the shutdowns will be relaxed and the economy will get moving again in the second half of the year. We will just need to take care and be diligent as many of our Asian neighbours are now.

So what do we plan to do to portfolio’s over the coming few months to repair the damage this shock has caused?At the present state of financial market stress, all financial assets are being sold in a search for liquidity and safety.

This includes defensive assets such as Government bonds or treasuries. These assets have maintained their value well over the last month, but with yields on a 10 year US treasury note only 0.85% per annum, we see little upside to holding these assets any longer. In fact, we believe Governments are going to have to take on debt like we haven’t seen since world war II to allow us to recover from this crisis, so the supply of Government debt is likely to rise materially over the next few years (see chart below). It will be worth it, to avoid depression and permanently high unemployment, and bankruptcies.

Projected US Public Debt

We intend to use proceeds from these sales to re-invest in assets that are likely to appreciate materially once sentiment reverses and confidence begins to be restored.

We believe over the coming months there will be some once in a generation opportunities to purchase growth assets that are presently being liquidated in this crisis.

Where do we see the opportunities at present?

Hybrids – Bank Hybrids have sold off as spreads have widened during this selloff. As stated above, we do not believe bank balance sheets are at risk of default. If spreads normalise over the coming 12 months as we expect them to, the return on Hybrids will be in the 20-30% range. We see much more upside in Hybrids than we do in corporate credit from current spreads.

Selected Equities and non-retail Commercial property- While we expect the equity market to rebound solidly in the second half of the year, the rebound will not be universal. We believe that market dynamics will be different and being in the right sectors and businesses will be essential.

The next 6 weeks should see a flood of capital raisings from businesses in sectors most heavily impacted by the virus or who had unsustainable business models in a more restrained environment – some of these businesses will not survive or face massive dilution.We are presently working through balance sheets to ensure our exposure will be to the stronger survivors and cyclicals who should benefit most from fiscal stimulus into the recovery. Consumer Staples, Healthcare, IT, commercial property (non-retail) and utilities appear to be those most favourably placed to benefit.

When do we think the time to start adding these positions will be?

Clearly, as we couldn’t pick the top of the market, we won’t be able to pick the bottom.

We have been consistent in that we believe the 3 following signposts will be a good indication that we are close to a bottom and to rebalance and add some more risk again to the portfolios:

The US Stimulus package is successfully passed and of sufficient size to provide support in the next few months.

The volatility in markets begins to subside and the vix falls below 35 (Currently around 80!)

We see a peak in the US case count (this should have occurred by mid-April).

If things come to pass as we expect, that means by late April, early May we would likely be going offensive to position for the recovery. As investors, the actions we take over the next 4-12 weeks will likely dictate the performance of our portfolio’s for the next 5 years.